Things to consider before shorting Canadian banks

Brian Bosse
13/07/2013

As the only Canuck in Vail….
RELEVANT DISCLOSURES Do not work for a CADbank. No positions in CADbank stock. No mortgage with any CADbank. Comfortable making money long or short VK called BB ‘thoughtful’…however he did not explain what that actually means!
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Terminology
• Canada has 5 big banks. All very similar, so we shall use STBANKX INDEX to represent them. [RY TD CM BMO BNS] • USA has many more names in the space. KBW’s BKX INDEX of 24 will represent them. • “Jingle Mail” - home owners impair a bank’s balance sheet by mailing back title when market value cannot cover the bank’s total exposure. • Rsqrd of GCB to UST rates is 85%.
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What are we taking about?
• Canada = 35M people. • 1.2% annum stable population growth since 1972
• (Toronto 2.6/5.6) (Montreal 1.6/3.8) (Vancouver .6/2.3) (Calgary 1.0/1.2) (Edmonton .8/1.1) (Ottawa .8/1.2) (Everywhere else 20M)
• Destination for people and money. 280,681 immigrants in 2010 • Imagine California with only 5 firms in loans, banking, brokerage • Those 5 banks are all Toronto HQs. A town with terrible commutes • Bank stocks are an important cornerstone for Canadian investors
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Contents
• • • • • • • •
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What the Shorts see Facts on the Ground CMHC data Toronto is ground zero Bank sensitivity to consumer debt What Brian thinks Shorts are missing Brian’s advice for shorts Name that Canadian!
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What the Shorts see

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• PICTURE – STBANKX exposed to consumer debt levels equal to US consumer levels in 2007. And housing bubble too boot! • THE BET – Housing rolls over. ERGO banks will be holding underwater mortgages and consumer debts gone bad. ERGO banks Istatement losses & Bsheets losses. • THE PRIZE - 1989 STBANKX had TRA of -29%USD 07/31/89 to 09/28/90, vs SPX -11.5 vs 10yrGCAN yield moved from 8-12%!]. • THE PRIZE - Great Recession BKX had TRA -27% 01/01/07-03/31/09 vs. SPX -44%
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History of the ‘Prize’

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The short thesis
All housing bubbles crush all banks, everywhere, because it was true in USA last time. [STBANKX 2013-15 = KBW 2007-09 = STBANKX 1989-90]

They are betting that huge wave of Jingle Mail is coming very soon. They have been making this bet, off and on, since 2008.

Would you buy Japan banks based on this chart?

Comparative Housing charts
250 Home Price Index (Jan 2000 = 100) 230 210 190 170 150 130 110 90 70 50 Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12

U.S. Case Shiller

Canada Terranet

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Not a robust comparison. FX adjustment kills the argument
230 Home Price Index (Jan 2000 = 100) 210 190 170 150 130 110 90 70 50 Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12

U.S. Case Shiller

Canada Terranet

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Facts on the ground

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National Median Family Income is 66k$
These places should have house prices way above National Average, and they do. no problem!
Montreal 220.5 Toronto 156.1 Ft. McMurray 144.4 Toronto 139.2 Toronto (Oakville) 133.8 Calgary 178.4 Toronto 150.6 Ottawa 144.0 Toronto 153.5 Toronto 133.7

4 adjustments needed. AND ALL make Canada look better than shorts think it is. A – add NPISH incomes to Canada data B – Add unincorporated debts to USA data C – Factor adjustment for NPISH size being larger in USA than Canada. We have no ‘non-profit’ schools and hospitals compared to USA. D – Adjust for core disposable income stability in Canada vs USA. Specifically 4% healthcare spending by consumers versus 17%, and that illness has less affect upon creditworthiness.

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Beware of Data Mirages
• This shows, via longer term perspectives, that VCR and YYZ are the problems. Teranet is mktcap weighted…average national income is not. • In fact the correct comparison is not USA to CAD, but NYC to VCR to YYZ. Because VCR and YYZ are also the destination cities for international investment money and money parking. In recent years the TRUMP/Shangri-La/4Seasons brands have all opened their 1st condo hotels in Toronto. Again – pricing these homes against average Canadian Income is a mismatch…because the incomes are not Canadian, the wealth is large, and if there is debt financing, CADbanks are unlikely to have supplied it. • ERGO these shorts are betting against an inflection in the FED’s QE4VR policy regarding 10yr rates…not against banks Istatements…they are just the pass-through vehicle. In fact even their Bsheet exposure is passed through. • YYZ income trades at 25% premium to CDN average. And the house prices are…25% premium too.

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These are hand calculated proxies for Home owner’s equity percentage, in each country. Both data sets are indexed to 100 level in 1990. We can clearly see that the two systems have shown different volatility characteristics. What about the Green line makes you think that a large ‘everyone is underwater’ moment is coming?

CMHC

Canada Mortgage & Housing Corporation
• Nearly 600$B insurance portfolio, 2/3rds of total. • CMHC is also overseen by OSFI. OSFI also oversees the banks • A Crown Corporation, owned by the Federal Government. • 5% minimum down, even for insured loans • CURRENT DEFAULT RATES ARE…

Loan Vintage Data

Toronto

154 Cranes
• Downtown Toronto is adding jobs, and people, faster than rest of country. • It is wealthier than rest of the country • It has higher income than rest of country • It’s core is pulling from its fringes • Skyline barely changed from 1990 until 2005. 2 huge current projects were 50 years overdue. • 500k Millenials can live+work w/o cars. Currently no children, and lifetime of earnings ahead.

Housing rollover cannot kill STBANKX

The 35$B annual pie

Income Statement overview (rbc)

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Quickie Comp. Chart (rbc)

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STBANKX shareholder base, eg.

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THOUGHT EXPERIMENT - When does Housing create an Existential Threat to STBANKX?
• 1st 20% down books to the owner. • Next 53% books to CMHC. Too simple a statement, but illustrative…2/3 of mortgages insured, times 80% LTV, is 53% • Ignoring the knock-on affects…bank exposure is to the bottom 27% of a fall in house prices, assuming that housing went to zero. ERGO – the OECD implied 48% correction would hurt, but not kill, STBANKX earnings
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What Shorts should focus on

Behavioural Framing Issues with “The Bet”
• Income Statements for STBANKX is more than mortgage lending. • Balance Sheet management is all that banking is really about. And the CADbanks have a long history of doing it well in conjunction with the OSFI. • Subprime Lending’ in Canada means LTV=80%. We prime those using CMHC insurance. CADbank balance sheets are explicitly indemnified, including legal costs.

• STBANKX are essentially GSEs of OECD’s best house on the street
• Even if 3 years of Real Estate vintage goes sour, the direct impact is only 12% on earnings, for 3 years. So housing is not an existential threat to these banks. Which makes shorting a timing exercise. • STBANKX current PE is 11. Divvy 4.1%. If we use 8x to represent book value, implied growth is 1.5%. So, how is this expensive versus 2% GDP growth? Paying 5% total borrow cost to find out is counterproductive.

• 50% consumer economy in CAD vs 70% in USA. And a lower CAD value sparks other sections of the economy, which benefits STBANKX. Resources&Manufacturing&Technology&FDI.
• According to Statistics Canada, growth of 25-40yrs old between 2011 and 2016 is 6.94% (490k)...these are the condo buyers causing a lot of cranes. 490k/couples/30stories/30units=272 cranes • Uninsured LTV runs 55% nationally

• No systemic ‘dumb money’ . Securitization is a non-event. • VCR & YYZ are 35% of housing value annual turnover, yet people compare house pricing to the national income??? • Non standard loans…23% USA 2006, 5% CAN 2005, 7% CAN 2012 • Mortgage vintages have not gone bad. • STBANKX controls many industries. Exchanges, AUM, Investment Banks, AUA, Student Loans, Credit Cards, Auto Loans, Toy Loans, HELOCs, Insurance, Regulations, Prime Brokerage, etc. • @ 4% Short Interest, STBANKX reaps 62M$ in cost of borrow from hedgies. [CM is 31B$mcap. 4%SI @ 5%annum is 62M$!!]. @ 1.5% NIMspread, 62M$ is like 4.1B$ in loans • All borrowers must qualify for a 5 yr fixed… even if they are asking for 3yr float. • No refi can take homeowners below 20% equity. Spec buying (non owner occupied) down&+ insurance. 25yr max amortization on all CMHC loans. 45 | requires 13/07/2013 20% | GOODMAN COMPANY, INVESTMENT COUNSEL INC. • No more CMHC backing on HELOCs. No CMHC on homes above 1M$.

Before deciding about Bubbles.
• • • • • • • Canada is recourse (except AB). Defaulting homeowners cannot walk. They declare and the bank has claim to other assets if Foreclosure does not make the bank whole as a secured creditor. Insurance applications are NOT vintage based. Each deal gets vetted & approved. So – no putbacks! Borrowers required to prove that the down-payment is theirs. Banks do not ‘compete’ to lend in USA sense (no interstate billboards for fishing boat loans). They are relationship lenders, aiming to take the entire fee wallet as recompense on any lowered interest rates offered. When large commercial loans made do turn bad, banks will either workout, take the a foreclosure hit, or sell the debt to vultures. ALL mortgages are term loans, regardless of amortization period. (3,5,7yrs) No NINJAs, No Liar Loans, No Teaser Rates, No Interest expense deductions, Max 2 CMHC’s per person VCR outperformance began in advance of 1999 Hong Kong handoff, and continues as Asian wealth needs to be stored offshore. Condo construction is tiny % of loan books. It is 80% loan to costs instead of LTV.


Advice to shorts

Brian’s Advice to Shorts
Wait for a clear catalyst which could topple the affordability of consumer debt levels. • I rate shock • Employment shock • US recession

The proper short basket must include Sovereign - CAD and GCB. *remember that GFC = housing bust + short term funding window @ zero + MBS investment writedowns. Not a simple analogy to STBANKX in 2013

Thank you very much

Questions & Video

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This presentation is solely the work of Brian Bosse. Although the author is a registered Portfolio Manager with Goodman & Company, Investment Counsel Inc. (“GICI”), this is not an official publication of GICI and the author is not a GICI research analyst. The views (including any recommendations) expressed in this material are those of the author alone, and they have not been approved by, and are not necessarily those of, GICI or its parent company, Dundee Corporation. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. The information contained in this presentation has been compiled from sources believed to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. No representation or warranty, express or implied, is made as to the fairness, accuracy, or completeness or correctness of the information, opinions and conclusions contained in this presentation. None of GICI, its directors, employees or agents, or any other person accepts any liability, including, without limitation, any liability arising out of fault or negligence, for any loss arising from the use of information contained in this presentation The information contained in this presentation is not investment or financial product advice and is not intended to be used as the basis for making an investment decision. This presentation has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Past performance is not indicative of future results and no returns are guaranteed. This presentation is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. No part of this publication may be reproduced without the express written consent of GICI and Brian Bosse.

Brian Bosse, CFA. Vice President, Portfolio Manager
13/07/2013